How is net present value (NPV) calculated?

Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment or project. NPV is calculated by determining the present value of all future cash flows generated by the investment and then subtracting the initial investment cost. This involves discounting the expected future cash inflows back to their present values using a specific discount rate, which reflects the risk of the investment and the opportunity cost of capital.

This calculation effectively tells you whether the projected earnings (in terms of present value) surpass the initial investment made. If the NPV is positive, it indicates that the investment is likely to generate more cash than it costs, which is a sign that proceeding with the investment would be beneficial.

In contrast, the other choices do not represent the correct method for calculating NPV. Adding all future cash flows does not take the time value of money into account and therefore misses a critical aspect of NPV analysis. Averaging past investments is not relevant to NPV calculation, as it involves looking backward rather than evaluating future cash flows. Adding investment costs to expected returns without discounting fails to properly account for the timing of the cash flows, which is essential in determining the present value.